“The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
Powell couldn’t have been any more precise in his annual address at Jackson Hole.
There’s no wiggle room. The Fed will cut rates in September. Even if the Fed had fully intended to pull the trigger next month, Powell could have given the Fed a backdoor, maybe something like, “The time MAY SOON come for policy to adjust.”
Soon signals September. May gives them an out.
But the Fed isn’t one-data point dependent. A strong jobs report for August or a disappointing CPI just days before the Fed’s September meeting won’t discourage Fed officials.
The Fed made its intentions crystal clear. It’s ready to start easing up on the monetary brakes.
Investors tip-toed into August and were greeted by an unexpected cyclone from Japan. However, as quickly as the storm entered our orbit, it moved on, and the S&P 500 Index is pushing toward a new high.
The equal-weight S&P 500 is trading at a record high.
August and September have historically been challenging months for investors.
While historical patterns sometimes have predictive value (and the month isn’t over), these aren’t hard and fast rules.
Economic fundamentals shouldn’t be discounted. In my view, fears of an imminent recession were overblown, and the Fed is gearing up to cut interest rates.
Rate cuts that coincide with a soft landing have historically supported stocks (mid-1980s, mid-190s, 2019(, while those that accompany a recession do not (2001 and 2008).
The ISM Manufacturing and Service Indexes both slipped below 50.
While manufacturing has been in a funk for a while, services have been red hot.
And nonfarm payrolls eased more than expected in April.
One month doesn’t make a trend. One month is simply a data point.
Two months is a line. Three months gives us a trend.
We’ve experienced head fakes before. Keep an eye on first-time jobless claims. It’s a pretty reliable leading indicator. A sustained tick higher would suggest business activity is slowing down.
We’re well into a new decade, and inflation is once again a headline. It affects consumers; investors; everyone.
Data Source: St. Louis Federal Reserve March 2024
Despite an unemployment rate that is stuck below 4%, despite strong job creation, despite a series of new stock market highs this year, consumer sentiment is in the dumps.
Why? Much has to do with high prices.
Inflation slowed more than most forecasters expected in 2023, and that’s great news, but progress has come to a grinding halt in the new year. Or worse, it’s re-accelerating.
That’s why they lowered their guard and started talking about an easier monetary policy, which, in turn, helped juice stock prices.
The CPI is no longer in a disinflationary trend. Instead, price hikes have accelerated in 2024, as evidenced by the graphic above.
Just as Powell retired ‘transitory’ in late 2021, he’s no longer blaming the calendar for price re-acceleration this year.
However, he believes the Fed’s current stance is sufficient to return the economy to price stability–eventually. Let’s hope he’s right. We don’t need a repeat of the 1970s.
Fly in the ointment
But, what if a 5.25-5.50% fed funds rate isn’t all that restrictive? Job growth is strong, wages are rising, and government spending is off the charts.
Boosting aggregate demand in the economy via federal spending (and no tax hikes) is a great way to pump up GDP and job growth, but it also creates a tailwind for inflation.
In some respects, we’re all paying for higher spending via inflation, which acts like a hidden tax.
Nothing seems to be getting in the way of rate cuts as the Fed maintains its dovish stance.
Hotter inflation in January and February. Nope.
Strong payroll growth. Nope.
An economy that usually surprises to the upside. Nope.
A core CPI stuck at about 4 percent—double the Fed’s 2 percent target? Nope.
The Fed’s creed
Neither snow nor rain nor heat nor gloom of night…nor a high core CPI nor upbeat job growth nor hot inflation numbers at the top of the year stays the Fed from a June rate cut.
That was the general message from the March Fed meeting, and Dow, S&P 500, and Nasdaq closed at new highs on Wednesday and Thursday.
Investors are chomping at the bit for the Fed to slash interest rates. Just a couple of weeks ago, March was to mark the first rate cut of the cycle, according to the CME’s FedWatch Tool.
And, going forward, the most likely path wasn’t simply a gradualist approach. The CME’s tool reflected (and still reflects) an aggressive series of rate cuts, up to seven 25 bp rate cuts at one point.
Yet, it’s not the first time investors have bet on a dovish Fed. It’s not the first time they jumped the gun on a Fed pivot or pause.
Honestly, I’m not sure why investors are so optimistic that the Fed will cave to their demands.
You’re thinking, “But hasn’t inflation slowed down?” It has. The core PCE Index is just below 3%. That would give the Fed cover to ease. The six-month annualized core PCE is just under 2%. That would also give the Fed cover to ease.
The core CPI has slowed but is near 4%, and progress has stalled. That’s far from the definition of price stability.
More importantly, GDP in the second half of 2023 expanded at an annual pace of over 4%. Nonfarm payrolls shocked just about everyone in January, rising by 335,000. Notably, the same thing happened last year when payrolls surged by about 500,000 in January.
The consumer isn’t backing down, fiscal stimulus is in the pipeline, and companies are adding to payrolls. If the Fed is truly data-dependent, I’m unsure what would justify the five rate cuts that investors currently expect, let alone the six or seven projected in January.
Put another way, there are few signs the economy needs that much monetary stimulus.
For starters, the Fed has never embarked on an aggressive easing without a recession. Do investors expect the ever-elusive recession to materialize this year?
Well, based on the recent series of highs in the market, the answer seems to be a resounding no. Recessions and bear markets go hand in hand; at least, that’s what 60+ years of market history tells us. If investors were fretting over a recession today, we wouldn’t be seeing major indices near highs.
Final thoughts
Mostly upbeat data are not conducive to an aggressive cycle. Besides, the Fed has openly opined on the lessons of the 1960s and 1970s. Inflation has slowed down, but we’ve been on this merry-go-round before.
So, why are investors so optimistic the Fed will aggressively backpedal on rates this year?
Wall Street analysts were unusually pessimistic as the year began. Should we have been surprised? Probably not. Recession forecasts were all the rage as the year began.
A recent story in Bloomberg News points this out. In fact, since 2000, analysts had not forecast a down year until 2023.
Despite earlier concerns, the economy has held up well this year, and major indices such as the S&P 500 Index are heading into yearend in positive territory.
Notably, analysts failed to call down years, including 2000, 2001, 2002, 2008, 2018, and 2022.
Partly cloudy with a big chance of uncertainty
Predicting the economy and the stock market can be challenging. It is not a straightforward process. Models rely on many variables. Get some of the variables wrong and the forecast can go awry.
We can learn plenty of lessons from this year’s missteps by the pros. But let’s keep it simple.
“Inflation remains well above our longer-run goal of 2 percent.”
“Inflation pressures continue to run high, and the process of getting inflation back down to 2 percent has a long way to go.”
“The labor market remains very tight.”
“We remain committed to bringing inflation back down to our 2 percent goal.”
The rhetoric is strong, but is the bark worse than the bite?
We just had another blowout jobs report, and core inflation is stuck above 5%.
But the Fed passed on hiking rates in June, and the Fed is penciling in just 2 more 25 bp rate hikes this year—that’s two of four meetings. That sounds like the very gradual pace of rate hikes we saw in the 2010s when inflation was hovering just below 2%.
Is the Fed really committed to getting inflation back down?
Last year, they talked a big game, and they followed through, much to the chagrin of investors. This year, I’m not so sure. Maybe it’s simply the fear that anything more than a mild recession could be lurking.
Over the past six to twelve months, there has been significant coverage and talk regarding a looming recession.
This level of attention from analysts, economists, and the financial media is unusual, as recessions typically catch us off guard. It’s only in hindsight that we recognize the signs that were hidden in broad daylight.
This time, however, it’s hurry up and wait… and wait and wait. Last week’s payroll report highlights that we’re still waiting.
Yet, the Fed is on board with a mild recession. It sees one developing later in the year.
The job market is flourishing, and inflation is more than double the Fed’s annual 2% target. However, central bankers are considering forgoing a rate hike next week in order to assess the impact of 10 straight rate hikes, which have raised the fed funds rate from zero to 5%.
The current series of rate increases is the sharpest since 1980. But even with a 5% fed funds rate, it’s not at a historically high level, particularly with inflation hovering around 5%.
Essentially, this means that the real fed funds rate is zero, and it doesn’t appear to be restrictive, given today’s still-high rate of inflation.
Once again, investors in some corners of the market were bracing for an earnings Apocalypse. Once again, fears were exaggerated.
Why? I think I can point to a couple of reasons.
First, analysts have historically been too conservative with their forecasts for corporate earnings. Q1 was no exception.
Second, we’re not in a recession… at least not yet. Fortune 500 companies are huge. Sure, they can execute well and expand their reach. But they aren’t immune to missteps. If they fail to execute, it can be reflected in sales and profits.
But because they are so big, most aren’t immune to the tailwinds and headwinds that an economic expansion or recession will bring. If folks are spending, they benefit. If folks are stingy, they feel the pain.
Earnings for S&P 500 firms will likely end up falling less than 1%. On an absolute basis, it’s not impressive. But analysts had been expecting profits to decline by over 5%.
In other words, it’s a beat, and on average, most companies are beating by a wider-than-historical margin.
It boils down to modest overall economic growth and an easy-to-clear hurdle.
